Institutional investors and shareholder class actions: when to participate?

By Michael Legg and Zein El Hassan.

Key Points:
Financial incentives will determine the role that institutional investors play in shareholder class actions.

Recent media reports have indicated that institutional investors have joined shareholder class actions, such as those against Aristocrat Leisure, Concept Sports and Sons of Gwalia, in large numbers. The role of institutional investors in shareholder class actions is not new as it has been established in the United States since at least 1995. However, the US experience is now of interest in Australia due to institutional investors being courted to participate in shareholder class actions. This raises questions about when an institutional investor should participate in a class action and in what capacity. This article responds to that question by drawing on the US experience, informed by differences with the Australian legal system, to suggest:

• whether to commence or participate in a class action will depend upon the potential recovery and costs involved. The costs include direct costs for solicitors fees and an adverse costs order if the case is unsuccessful. There are also indirect costs such as management time, complying with discovery and the impact on business relationships.
• costs can be ameliorated through litigation funding or through the role taken in the class action, namely lead plaintiff, a group member or a free-rider ie. an absent member of the class who only comes forward to collect a recovery. Fewer costs means less control over the class action.
• guidelines or policies for participation in class actions should be adopted to ensure thorough consideration of the benefits and costs of participation..

The US experience of institutional investors and securities class actions

In 1995 the US Congress enacted the Private Securities Litigation Reform Act ("PSLRA") which resulted in mandatory procedures for the appointment of a lead plaintiff in securities class actions. In general, PSLRA created a presumption that the "most adequate plaintiff" was the claimant with "the largest financial interest" in the suit. The aim of PSLRA was to encourage institutional investors to take the lead in securities class actions so as to prevent lawyer-driven suits. In particular the US was concerned about "strike suits" where lawyers with pre-existing arrangements with small shareholders would commence suit in the hope that a corporate defendant would settle the case because it was cheaper to pay the settlement than incur the costs of defending the matter. In the US each party bears its own costs in litigation so even a victory for the defendant would be expensive.

The PSLRA sought to align institutional investors' financial interests with the public interest in a legal system that redresses real wrongs for the benefit of those harmed. The involvement of an institutional investor was expected to result in more favourable settlement terms for class members, lower legal fees, fewer strike suits, more adjudications of class actions, improvements in corporate governance and greater deterrence of securities fraud.

In April 2006 an empirical study by NERA Economic Consulting reported that 38% of settled cases had an institutional lead plaintiff and those cases settled for one-third more. However for each of the headline-grabbing settlements there are still many cases without institutional investors at the helm. The reasons put forward for not taking the lead in a class action are:

• instituting and managing litigation are not within the institutional investors’ area of expertise - their skills are in fund management or investment decisions.
• litigation takes up management time so that there is an opportunity cost - could the resources be better spent on the main business?
• concerns that the institutional investor will need to give discovery resulting in not just further costs but the potential disclosure of proprietary information about how investment decisions are made.

Institutional investors can avoid many of the costs set out above and still recover by simply being part of the class and free-riding on others’ efforts. Some institutional investors do not participate in class actions at all because:

• the companies they invest in are also their clients. For example, banks and insurance companies hold investment portfolios but also want corporations to use their services.
• where an institution retains an investment in a going concern entity on which they have lost money the resources devoted to the class action reduce the resources available for dividends or investments. The institutional investor effectively funds their own pay-out from the litigation.
• the litigation will provide a minor return to the investor but a substantial gain for the lawyers thus promoting further litigation of limited utility.
• "There but for the grace of God go I", which comports with findings that over a five year period a US public corporation faces a 10% probability that it will face at least one securities class action suit.

However, those institutional investors who did participate would have received a share of settlements from securities class actions such as $US 7 billion from Enron, $US 6 billion from Worldcom Inc, $US 3.5 billion from Cendant Corp and $US 2.6 billion from AOL Time Warner Inc.

The frequency of securities class actions in the US has seen institutional investors adopt litigation guidelines that weigh the above factors so as to guide decision-making.

What role for Australian institutional investors in shareholder class actions?

Shareholder class actions are still in their infancy in Australia as compared to the United States. Nonetheless the incentives that Australian institutional investors face will influence the role they play in shareholder class actions. Those incentives are altered by two main differences between the US and Australia - the rules governing legal costs and the rise of litigation funding in Australia.

The Australian litigation costs regime provides an inducement for a well-resourced institutional investor to avoid the role of lead plaintiff (or representative party in Australian terminology) in a class action. Generally a losing party is liable for the other side's costs, however, in the class action context that is limited to the lead plaintiff only and does not apply to other group members. Consequently, institutional investors can place themselves in a win-win situation by not being the lead plaintiff because they will recover if the lead plaintiff succeeds but will not be liable for any costs if the lead plaintiff is unsuccessful.

The advent of litigation funding changes the above calculus as a funder may indemnify a lead plaintiff for any costs orders against the lead plaintiff and pay the legal costs of the suit in exchange for them bringing the class action and paying a percentage of their recovery, usually 30-40%, to the funder. The litigation funder can substantially reduce the risk of pursuing litigation, can monitor the lawyers (but someone still has to monitor the funder), and marshal expertise on the prospects of success. If the institution has sufficient funds at stake it may want to take on the lead plaintiff role so as to maintain control over the litigation.

While many of the explicit costs are ameliorated the costs of discovery and opportunity costs remain. The institutional investor, even if indemnified against costs by a funder, must factor in the Australian costs regime because it provides different incentives for defendants than the US system. A successful defendant can recover a proportion of its costs so there is a greater incentive to fight litigation with the result that discovery will take place and cases may go to trial. The institutional investor may therefore face larger opportunity costs and greater intrusion into their business. These costs may see an institutional investor prefer a less high profile position in the class action.

Alternatively the institutional investor may prefer to avoid having to share its recovery with a litigation funder - which is possible under the opt-out class action procedure that applies in the Federal and Victorian Courts because the institutional investor is automatically part of the class action - unless they take steps to actively exclude themselves. As a result if a funder brings an action for some shareholders, all of the shareholders benefit. The institutional investor can free-ride and so may be better off simply monitoring class actions against their investments and only coming forward once there are funds to be distributed. In the other jurisdictions closer examination of how the class action is structured will be needed to see if an opt-out approach is adopted.

Institutional investors also need to consider if they should bring an action alone without relying on the class action procedure or use the class action but take control of it rather than sharing control with a litigation funder. The former course may be necessary if their interests diverge from other group members or if additional group members give rise to additional legal issues that increase costs or weaken a cause of action. However, the additional weight of numbers may allow the institutional investor to bring greater pressure to bear for a substantial settlement. The visibility of a class action is far greater than commercial litigation between two corporate entities.

As in the US it is financial incentives which will determine the role that institutional investors play in shareholder class actions. Accordingly institutional investors must give careful consideration to whether a law suit has merit, whether a class action is the appropriate litigation vehicle, if a law suit may cause unintended harm to beneficiaries such as when the class action bankrupts the defendant causing shares to be worth even less, whether being the lead plaintiff, a group member or a free-rider is sensible, whether litigation funding is desirable or an unnecessary expense.

For further information, please contact Michael Legg.